How to spot a bad mutual fund

The back-and-forth between the two ETF giants carries a number of messages for investors on how to capture those pennies and turn them into real dollars. The problem is that both companies were so busy crowing about their moves that most investors missed what was said between the lines

On Sept. 21, Schwab
SCHW, -0.88%
lowered fees on its exchange-traded funds to make them the lowest-cost entries in their categories. The move came just a week after BlackRock Inc.
BLK, -0.72%
had announced plans to cut costs on its iShares line, and was a shot across the bow of Vanguard, which has long been acknowledged as the industry’s low-price leader.

Schwab U.S. Large Cap ETF
SCHX, -0.18%
for example, saw its expense ratio cut in half, to 0.04%; like most of the issues in the deal, that price point was 0.01 points better than Vanguard’s entry in the similar space.

Vanguard’s response came on Oct. 2, when it announced that it would adopt new benchmarks over the next six months for close to two dozen index funds, a move that would allow it to cut costs just enough to retake the cost lead over Schwab.

Shareholders aren’t getting rich on the savings. Schwab’s 50% cut in costs on U.S. Large Cap saves shareholders 40 cents on every $1,000 they keep in the fund for a year. Vanguard’s cuts, in some cases, will save its shareholders half that amount. All told, an investor with $10,000 in the ETFs is likely to see less than $5 in savings over the next year.

But focusing on the savings misses the point. The real lessons here are for any investor who is pursuing an indexing strategy without the lowest-cost ETFs. Those lessons are:

1. Traditional index mutual funds are out; use the ETF in the same space

With the exception of a few cost leaders — mostly institutional funds requiring big holdings — ETFs are dramatically cheaper than traditional funds covering the same indexes. So while investors in a fund such as T. Rowe Price Equity Index Fund
PREIX, -0.21%
won’t complain about an expense ratio of 0.30%, they are paying at least six times more than the best of the ETFs. Making that change would boost return an extra quarter-point per year, and that adds up.

And the T. Rowe Price offering is a good traditional fund. Lipper Inc. shows plenty of S&P 500 index funds — particularly B- and C-share classes — with costs well north of 1%.

The one advantage traditional funds have is that an investor can dollar-cost average into the fund without paying repeated commissions, but no-transaction-fee ETFs offset this advantage. Index ETFs have a slight edge in tax efficiency over traditional index funds too.

2. Use ETFs for index investments, even if that changes what you keep inside and out of retirement accounts

A lot of investors settle for high-cost index funds because they are in the retirement plan. Again, that’s a mistake from both the expense and the tax standpoint.

If you want index funds and the only options in your retirement plans are costly ones, do your indexing outside of the plan and in taxable accounts, and use the employer’s plan to build your portfolio around that index core.

And if you hold high-cost index funds in a plan from a former employer, it’s time to convert that account to a self-directed IRA, allowing you to move your core holdings into the low-cost ETF equivalents. Shaving those costs can add an extra percentage point or more to returns; that’s free money, and particularly important to capture at a time when yields are so low and the market is particularly nerve-wracking.

3. Stop worrying about who built the index; what matters are the assets it covers and the cost for getting that exposure.

There are a lot of index choices, and even academics and management wonks have a tough time figuring out the difference performance-wise between the index providers. Vanguard’s change represents its third major index provider in recent memory.

A. Michael Lipper, president of Lipper Advisory Group, founder of Lipper Inc. and no stranger to putting together indexes, said: “Remember that indexes are constructed, in effect, by publishers, not investment managers. The index is not put together as ‘This is a great long-term portfolio,’ but is typically the largest stocks in a sector or market, or some special group within a market”

For investors, he added, “It’s more about being big stocks or being in a certain sector than it is about being good stocks or the best in the sector.”

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